China’s Minsky moment intensifies

Via Zero Hedge:

Step aside Baoshang Bank and Bank of Jinzhou, it’s time for Chinese bank bailout #3.

Last month, when reporting on the imminent failure of yet another Chinese bank in the inglorious aftermath of Baoshang Bank’s late May state takeover, we dusted off a list of deeply troubled Chinese financial institutions that had delayed their 2018 annual reports…

… and noted that the #2 bank on this list, Bank of Jinzhou recently met financial institutions in its home Liaoning province to discuss measures to deal with liquidity problems, and in a parallel bailout to that of Baoshang, the bank was in talks to “introduce strategic investors” after a report that China’s financial regulators are seeking to resolve its liquidity problems sent its dollar-denominated debt plunging.

Just a few days later, that’s precisely what happened, when in late July, Industrial and Commercial Bank of China (ICBC), the country’s largest lender by assets, China Cinda Asset Management and China Great Wall Asset Management, two of China’s four largest distressed debt managers, said on Sunday they would take stakes in Bank of Jinzhou.

To be sure, there was some token debate over the semantics: was this bailout a nationalization or a state-bank funded takeover:

“For Baoshang Bank, the government took a state takeover, while for Bank of Jinzhou, the government introduced some state-owned strategic investors,” said Dai Zhifeng, analyst with Zhongtai Securities Co; in reality both were government rescues, only in the latest case Beijing used state-owned bank intermediaries.

“The latter approach is more market-oriented and showcased the determination of regulators to resolve problematic banks, while injecting confidence into the market,” Dai said, although when stripped of all the pig lipstick, what just happened in China is that another major bank, one with $100 billion in assets, just collapsed and received a government-backed rescue.

The bigger problem, and the reason why Chinese bank stocks have tumbled ever since the Baoshang Bank bailout, is that investors (and depositors) were worried that now that Beijing has started down the path of bank bailouts, it was unclear where it would stop.

And so, fast forward to this week when overnight, the SCMP reported that China’s sovereign wealth fund has taken over Heng Feng Bank – the bank at the very top of the list shown above, one with roughly $200 billion in assets –  a troubled lender linked to fugitive financier Xiao Jianhua, in the third case in as many months of the state exerting its grip over wayward financial institutions.

According to the report, Central Huijin Investment, a subsidiary of the China Investment Corporation that acts as the Chinese government’s shareholder in the country’s four biggest banks, emerged as a strategic investor in Heng Feng, according to a brief report overnight by Shanghai Securities News, published by state news agency Xinhua.

The investment was a breakthrough in Heng Feng’s debt restructuring led by the Shandong provincial government, the state-owned newspaper said, without citing a source or providing financial details. Huijin’s investment would increase Heng Feng’s capital adequacy, improve the troubled bank’s management and enhance its operational capability, the paper said.

In short, a 3rd Chinese bank in as many months received an implicit (or explicit) state bailout, and with the dominoes now falling, it’s just a matter of time before most if not all of the banks shown in the list above collapse.

Some more details on bailout #3:

Heng Feng, based in Yantai city, was founded in 1987. It operated 18 branches and 306 sub-branches across the country. It is among more than a dozen city-level and rural lenders that had been put on notice by the authorities for a shake-up, as regulators step up their programme of cleaning up financial malfeasance and profligate lending.

It’s also the second of several banks in Xiao’s financial empire to be put under state ward, after the May 24 nationalisation of Baoshang Bank in Inner Mongolia’s Baotou city. As we reported back in May, Xiao’s Tomorrow Group, which owned 89% of Baoshang, had misappropriated large sums from the bank, triggering serious credit risks that prompted the government to step in, the central bank said. Xiao himself had not been seen in public since he was persuaded to return to mainland China from Hong Kong on the eve of the 2017 Lunar New Year to help with investigations into his financial affairs. Like so many other former oligarchs, he simply disappeared somewhere deep inside China’s “corrections” apparatus.

As the SCMP notes, at its apex, Tomorrow Group owned stakes via proxies in hundreds of Chinese listed companies, including at least 10 banks, the China Banking & Insurance Regulatory Commission said on June 9.

It all ended with a bang, however, with the Baoshang Bank  seizure in late May.

Then, as we reported two months later, Baoshan was joined on July 29 by Bank of Jinzhou, which received the backing of three Chinese financial institutions, including Industrial & Commercial Bank of China. ICBC put 3 billion yuan (US$436 million) into Bank of Jinzhou, and assigned at least four senior executives to manage it. Cinda Asset Management and Great Wall Asset Management would also pour funds into Bank of Jinzhou.

The change in strategy, where Beijing was now openly seizing or bailing out insolvent banks – Baoshang was the Chinese government’s first nationalisation of a private bank since 1998 – led to a collective collapse in the stock prices of China’s listed banks, driving their valuations to record lows, amid fears that the shakeout would affect more lenders, and that the largest and best capitalized institutions would be called upon to bail them out.

That’s precisely what is happening right now, and unfortunately it’s about to get worse for a simple reason that was all the rage back in 2015 – namely the soaring amount of Chinese NPLs, a number which has been drastically massaged by the banks, regulators and politicians, to make China’s banking system appears safer than it was (see “CLSA Just Stumbled On The Neutron Bomb In China’s Banking System“). As the SCMP notes, the level of non-performing loans among local lenders licensed to operate within city of urban centres were at 1.9% of their total lending at the end of March, worse than their larger peers, according to CBIRC data. The real number is likely orders of magnitude higher.

These local, city banks were also the least capitalised among all bank categories, with 12.6% capital adequacy ratio, compared with 18.3% in foreign banks.

It gets even worse when one looks at China’s rural commercial banks, which are licensed to serve villages and smaller towns, and which had 4.1% of their lending classified as bad loans, CBRC data showed. That compared with the 1.1 per cent average among larger nationwide commercial banks, and 0.8 per cent among foreign banks, the data showed. None of those numbers is remotely close to reality, and with China’s economic growth now sliding, it is just a matter of time before things get far worse.

Incidentally, just days before the Heng Feng rescue, JPMorgan correctly downgraded China’s banks due to increasing pressure for banks to support growth agenda as macro risk escalates:

The J.P. Morgan economics team revised down its GDP growth forecast for 2020 by 0.1ppt due to the recent sharp turn in Sino-U.S. trade negotiations. But even prior to that, declining PPI and industrial profits growth, suggesting declining debt-servicing ability and weakening cash flow for Corporate China, increase the risks that banks will be asked to support macro growth at the potential expense of profitability. Recent official PBOC comments on an accelerating interest rate liberalization process are illustrative of such rising risks.

Additionally, JPM cautioned investors to stay away from Chinese banks as, “(1) we cut our NIM and earnings estimates to factor in potential NIM compression due to interest rate  liberalization; (2) banks’ re-rating path comes to a halt, at least for now, due to the re-leverage of Corporate China leading to debt concerns; and (3) rising concerns of failed small banks contaminating the balance sheets of large banks may lead to de-rating pressure on large banks.”

It now appears that Beijing has indeed picked a model where concern (3) is especially valid, as large banks will be brought in to bail out smaller, insolvent ones (think JPMorgan and Bear Stearns), in the process “contaminating” their balance sheets, as what until now was a localized financial weakness diffuses across the entire banking sector.

Terrific stuff. I still don’t think that this ends in China’s own “Lehman moment”, a sudden stop in credit availability. But the dizzying daisy chains of counterparty risk in Chinese banks are clearly pulled taught and some are snapping. As Goldman reports:

…the sustained spikes in intraday repo rates suggest that some banks are still under pressure and are having to pay higher costs to obtain funding in the interbank market. A number of action has been taken to ease concerns regarding credit risk at smaller banks, including the recent equity injection into Bank of Jinzhou by ICBC Financial Asset Investment Company and China Cinda Asset Management

With no end in sight this is obviously going to weigh on credit issuance and growth at the margin, if via no other channel of contagion than confidence.  To wit, China economist Wei Yao at Society General:

It would not be an overstatement to say that Baoshang’s fallout is a milestone in China’s deleveraging reform and financial liberalisation. The deleveraging process is bound to expose weak institutions along the way, and it is only a matter of time before counter-party risk reaches the interbank market. …When the deleveraging process enters the very core of the financial system, the risk of things going terribly wrong rises. We still think China has a chance to pull through without a financial crisis, given the Chinese government’s control over many things…but we will be keeping a close eye on interbank developments, as this may be the source of under-appreciated risk for the global economy. We are not yet convinced of a clear recovery trend. Against a backdrop of continued trade uncertainties and deterioration in the liquidity conditions of small financial institutions after the PBoC’s takeover of Baoshang Bank, the economy remains on shaky ground.

That’s a good summary. China owns many of the banks so has a better chance of heading this off before it metastises into outright crisis. That said, struggling growth then creates other issues. Interest rates will need to fall. Bond markets have begun to price it already:

The early year optimism of a Chinese credit rebound leading to stronger growth has been replaced by tumbling yields in a dangerously bearish pattern that looks likely to break yields significantly lower. And that poses the real risk, via George Magnus:

A weaker currency will hurt Chinese consumers, who will pay more for imports, and hinder the intended shift in the economy to a more consumer-oriented structure. It will raise the credit risk and vulnerability of Chinese property and other companies that have been borrowing increasing volumes of dollars in the past few years. It will almost certainly encourage residents to try to evade capital controls and place money offshore. This happened in 2015-16 too, though the strengthened capital controls regime since then is likely to be more effective for the time being.

…As far as economic activity is concerned, the yuan’s move through 7 almost certainly reflects concern over the weaker trajectory of the economy, in which trade plays a relatively small direct role, though a cumulatively more important one. It’s not only the effect of tariffs that filters through China’s economy, but the loss of productive capacity as a rising number of firms move supply chain operations, and jobs, outside the country. A major Chinese investment bank recently suggested the industrial sector has lost about 5 million jobs in the last year, almost half of which are attributable to the trade war.

The yuan’s move appears to reflect frustration at the lack of progress in trade talks, and specifically the refusal of the U.S. side to remove tariffs as a condition for any Chinese concessions. The depreciation will be managed for the time being, but it’s unlikely to stop. With time, the rapid expansion of financial assets in China, combined with political pressures, will probably lead to a much greater decline.

The macro implications write themselves in an intensified end of cycle rerun of 2015:

  • crashing EMs as Chinese competitiveness soars;
  • crashing commodity prices;
  • a strong USD on safe haven flows, making the first two worse;
  • a tsunami of deflation emanating from China;
  • stocks crash and bonds boom;
  • the Australian dollar craters.

I’m not at all sure that the yuan devaluation is a trade war gambit by Chinese authorities. It looks more like the natural consequence of China losing control of its economic model as the trade war crashes into its efforts to deleverage. Chinese authorities appear happy enough to let that take its course, via Bloomie:

The People’s Bank of China late Friday called for a “rational” view on current headwinds, signaling that the targeted approach to shoring up output would continue.

…“Policy makers are fine with the current state of the economy,” said Larry Hu, head of China economics at Macquarie Securities Ltd. in Hong Kong. “But if growth continues to slow, at certain point, the priority will shift to growth stabilization.”

…China’s leadership appears to want to manage the economy’s long-term slowdown rather than arrest it, and smooth shorter-term weakness in consumption and output with about 2 trillion yuan ($283 billion) in tax cuts, as well as localized investment incentives.

Even if it dodges outright crisis during this gathering slowdown, China will struggle to stimulate meaningfully to underwrite any global growth rebound.

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